Why CRE Investors Should Use Financial Modeling

Whether you’re a new investor or have been playing the game for a while, real estate financial modeling offers a sophisticated financial analysis to help determine an asset’s potential ROI. Most investors have a pretty good handle on the formulas, metrics, and numbers necessary to guide the calculations for their strategy and action plan.

And that’s a good thing, since you’ll use a different financial modeling plan depending on your goals. Renovating and updating an old apartment requires a different strategy than building a new medical office building. Acquiring and converting a property from a retail store into warehouse space? That’ll require different modeling and pro forma than a traditional resale purchase.

Ready to start financial modeling—or up your game? Follow these steps:

1. Specify the project you’re modeling and its asset class, whether it’s office, residential, retail, short-term rental, storage, or others.
2. Identify the assumptions you’ll use to inform financial modeling of investment scenarios like:
   • Management costs
   • Operational expenses
   • Rents
   • Vacancy rates
   Market rents, for example, factor more into your modeling if you’re building a new multifamily structure. Buying resale? You’ll rely, instead, on rent rolls for the data you need. Key to success is ensuring your familiarity and understanding with the particular asset class (and market) you’re targeting. Otherwise, you run the risk of creating inaccurate pro forma models.
3. For this step—often referred to as underwriting—you’ll need the info you gathered in step one and two to develop and build your pro forma. Pro formas don’t have to involve advanced software. A simple spreadsheet works just fine, too. The most important element requires accurately entering the numbers associated with your transaction. This data creates a holistic picture of your asset’s performance according to different scenarios. You can adjust the numbers in your model, whether it’s the amount of money you put down, the amount of rent you charge, the amenities you offer to increase rents or shrink costs, etc. No matter what, don’t skip this step or approach it with a slapdash attitude or you may end up with very inaccurate results.
4. Now it’s time to examine the real estate pro forma metrics looking at cash flow, cash-on-return (CoC), and internal rate of return (IRR). Put yourself in the roles of an equity and a debt investor and compare the returns to average returns of other asset classes. From an investment perspective, do the returns look favorable?
5. Don’t forget to calculate exit strategies, too. Sometimes numbers just don’t add up. When that’s the case, having a plan ahead of time helps alleviate financial stress. Consider your options:
   • Can you sell the asset?
   • Can you subdivide and sell units individually?
   • Is the space convertible for use as a different asset?

Real Estate Modeling Metrics

An important reminder: not all metrics are weighted the same. Their importance can depend on asset type, specific type of RE transaction, and even your timeframe. The following metrics are critical for conducting accurate RE financial modeling:

• Capitalization (or cap) rates are a more simplified ROI calculation and handy for comparing different assets or markets and for factoring the cost to acquire an asset. So for example, if your modeling generates a 10% cap rate, you can expect approximately that return over 12 months. Use the property value and net operating income (NOI) to calculate cap rates. 
• Cash flow refers to the net funds remaining at the end of a set period—typically a month or a year. If you find the number in or close to negative, the real estate modeling you conducted may’ve highlighted a poor investment that requires reassessment.
• Internal Rate of Return combines the value of a real estate asset with the time value of money, calculating a return on an annual basis. Thinking about an investment asset? The IRR is a definite requirement.
• You can calculate net operating income by subtracting all expenses—except debt service—from the revenue. NOI provides a yearly return figure which you can combine with other metrics (like the cap rate) to determine an asset’s overall value. You can also use NOI to calculate the value of before-and-after scenarios like a development or renovation project. 

What if…

In an ideal world, you could anticipate any possibility like, for example, a global pandemic. But in reality, even the most thorough preparation can’t account for everything. That said, you can use RE financial modeling to evaluate some potential “what if” scenarios, like skyrocketing vacancies, real estate bubbles bursting, or tenants finding themselves unable to pay rent.

It’s not a bad idea to factor a few defensive strategies into your financial modeling document. The following defensive modeling techniques are worth considering:

• Consider your strategy if faced with zero or negative appreciation over five years. Use your modeling to calculate your numbers should RE prices drop or stay flat because of a market correction.
• Factor in capital expenditures (capex) like unexpected repairs—a new roof, dead furnace—significant cost overruns during a renovation. Factor in capex and overruns and run your modeling to evaluate your asset’s performance under stress.
• Financial modeling needs an interest rate for your debt, but what happens if interest rates rise? Current interest rates are sitting between 3% and 4%. But what do your numbers look like when you increase interest rates to 5%, 6%, or 7% and run your model? Does the investment still make sense? 
• As an investor holding properties, occupancy matters. When you run your model, factor in vacancy scenarios from 10% to 40% or 50% to find your break-even point for your asset.

Protect Yourself from Bad Decisions

The ultimate justification for mastering and using RE financial modeling? It empowers you to protect yourself from bad investments. Is it 100% accurate 100% of the time? No. And that’s okay.

Combining investing metrics and your pro forma will enable you to estimate accurately whether a particular investment makes a good addition to your portfolio—and your goals. Plus you’ll strengthen your modeling and numbers when you also consider defensive scenarios to identify possible situations with the power to transform a solid investment into an awful one.

Regardless of your CRE acquisition, development, or value-add project, it’s imperative that you can show—and explain—using metrics and numbers, your potential asset’s value. This data matters for you and other potential co-investors, too.

Whether you’re preparing to take the plunge, want to increase your portfolio, or need help assessing potential new investments, the experts at CREA United can help.